Stock Bear Looms

The US stock markets have enjoyed a dazzling year, levitating to a long series
of new record highs. But this relentless advance has stalled in August, with
selling pressure mounting. Even most of the bulls readily agree that a material
selloff is overdue after such a mighty run. But actually the odds are high
this necessary retreat will extend well beyond normal pullbacks or even corrections
into a new cyclical bear.

The mere idea of a looming stock bear is certainly heretical these days, but
this is not surprising. By early August, the flagship S&P 500 stock index
(SPX) had powered an astounding 152.7% higher since March 2009! Being so deep
into such a spectacular cyclical bull has naturally left speculators and investors
very complacent. Most have forgotten that markets don't move in one direction
forever, they flow and ebb.

Still, late in mature cyclical bulls the ever-rising chances for the birth
of a new cyclical bear are the last thing traders want to hear. So let's shelve
that controversial thesis for now and start at common ground. Nearly every
smart bull either expects a material stock-market selloff or thinks one would
be very healthy. And technical and sentimental indicators are nearly unanimous
in declaring the SPX very overbought.

Discussing all of these would require a sizable tome, but here's an overview.
The SPX is stretched far
above its trailing 200-day moving average. Complacency is extremely
high and fear non-existent as measured by key sentiment gauges. 2013's
SPX levitation has been on low and dwindling volume and narrowing market breadth,
with fewer and fewer individual stocks maintaining the rally's momentum.

Students of the markets can elaborate on these major topping indicators in
depth, and expound on dozens more. So the bears and smart bulls alike definitely
agree that some kind of material selloff in the US stock markets is either
already underway or imminent. The only real questions are about its ultimate
magnitude and duration. The difference between a down day and a bear market
is simply one of degree.

This is reflected in how material stock-market selloffs are categorized. Anything
under 4% is merely a series of down days without any formal name. When selloffs
extend from 4% to 10% off their preceding highs, they are called pullbacks.
Once they forge over 10%, they become known as corrections. And if the
selling continues long enough to push them over 20%, these selloffs become cyclical
bear markets.

Pullbacks are fairly common in cyclical bull markets, usually on the order
of 3 or 4 per year. Corrections are considerably rarer, only happening about
once a year on average. Both types of selloffs are critical for keeping bull
markets healthy. They act to rebalance sentiment, bleeding off greed before
it grows excessive enough to threaten the bull market's very existence. Selloffs
are an essential safety valve.

One of the primary reasons a material selloff is so overdue today is the remarkable
lack of them since mid-November 2012 when this year's relentless levitation
was born. During the 9 months since, there has only been one pullback and zero
corrections. As this first chart shows, this is very anomalous. The longer
a bull market goes without a material selloff to rebalance sentiment, the more
precarious it gets.

Even by the precedent of today's cyclical bull, the recent lack of material
selloffs is striking. The SPX is rendered in blue below, with every pullback
and correction of its entire bull run noted in yellow and red respectively.
Especially the past year or so is really conspicuous for the absence of these
healthy and essential events. The benchmark VIX fear gauge is also shown in
red, warning of extreme complacency.

In the 8.5 months between mid-November 2012 and early August 2013 where the
SPX soared 26.3% higher, there's only been one material selloff. And at 5.8%,
it was merely a smallish pullback running between late May and late June. There
were minor series of down days amounting to 3.1% in late December, 2.8% in
late February, and 3.2% in mid-April, but they didn't even approach pullback
magnitude.

As of the middle of this week, August's nascent SPX selloff had grown to 3.9%.
But all these selling events were very minor. The smaller the selloff, the
less greed it bleeds off and thus the more sentiment remains out of balance.
Prior to 2013, the average pullback in the SPX's entire mighty cyclical
bull was over 7.0%. So the lone 5.8% in the past 9 months' incredible levitation
is far from sufficient to rebalance.

And that explains the rampant euphoria plaguing the stock markets this year.
The financial media has been bursting at the seams with analysts and traders
touting stocks as the only place to be. Many have been arguing a correction-magnitude
selloff is all but impossible! Talk about hubris. The longer any bull
market goes without big-enough selloffs to deflate greed, the more this dangerous
emotion flourishes.

Thus long stock-market levitations without material selloffs inevitably lead
to full-blown corrections. The last example occurred back in mid-2011, when
the SPX corrected sharply. Much like today, it had spent 9.9 months levitating
with only two mild pullbacks. So when the selling finally arrived, it was big.
So much complacency and greed had built up that it took a serious 19.4% selloff
to fully eradicate that imbalance.

The parallels between that last SPX levitation and today's are ominous. Measured
by that flagship index, the stock markets had climbed 33.3% in 9.9 months.
Today we are at 26.3% in 8.5 months. The second pullback of that earlier levitation
occurred late in it, and was relatively mild. A slightly-higher secondary top
was seen soon after as the perma-bulls foolishly refused to heed the dangers
of overbought markets.

Sound familiar? The technical pattern we've seen in recent months matches
the early-2011 topping pattern remarkably well. A long SPX levitation sans-pullbacks
generated extraordinary complacency and greed, and the initial mild pullback
was ignored by the bulls. Their topping-indicators-be-damned buy-the-dips mentality
was able to bully the SPX up to a secondary high on low volume, but
it soon failed too.

And thus a correction arrived then and is certainly overdue now. On average
a correction-magnitude selloff happens about once a year in a healthy cyclical
bull market. As of early August's recent high, the SPX had gone a breathtaking 22.0
months without a correction! That just boggles the mind. This bull's previous
spans between corrections were merely 13.5m and 9.9m. Never has one been more
overdue.

Corrections are easy to comprehend in the abstract, but are scary events to
weather. They force stock prices down so close to bear-market territory that
most of the greedy traders who were hyper-bullish at the preceding top totally
capitulate. Back in both mid-2010 and late
2011just after this cyclical bull's previous corrections, I wrote
hardcore contrarian essays that were very bullish when everyone else was terrified.

Corrections drag the great sentiment pendulum from extreme greed and complacency
at the preceding top to extreme fear and despair at that selloff's nadir. A
merely average correction is 15%. Measured off the SPX's latest early-August
peak, that would hammer the SPX back down to 1453. That's not only 11.5% lower
than this week's levels, but would erase the SPX's gains for this entire calendar
year!

But it's been so darned long since this cyclical bull has seen a necessary
and healthy correction that I can't imagine it will be small or average. Complacency
is always high at major toppings, as measured by the low VIX. Since this implied-volatility
index effectively measures prevailing fear, a low reading shows the absence
of it which is complacency. Recent months' VIX lows have revealed extraordinary
complacency.

So even if this cyclical bull is alive and well and has years left to run
as Wall Street analysts have boldly asserted all year long, a big correction is
overdue and inevitable. The last correction was 19.4% in mid-2011, which is
about as big as they can get. A similar event today off the recent highs would
crush the SPX down to 1378, another 16.1% below this week's levels. Just imagine
the havoc that would wreak!

Round that big-correction target to 1375. This mighty cyclical bull first
challenged 1375 in April 2011, and first achieved it a year later in March
2012. So at the nadir of the next correction, somewhere between 1.4 and 2.3
years of this entire 4.4-year-long cyclical bull's gains will have vanished!
Both investors and speculators alike will have had their wills broken by that
point, being extremely pessimistic and bearish.

Remember that the difference between a down day and a cyclical bear market
is merely one of degree. There is simply no arguing that the US stock markets
are way overdue for a major correction. And once that comes to pass, and the
SPX is 17%, 18%, 19% off its recent peak, it won't take much additional selling
to push it over that 20% threshold. One big down day would do it. That would
make a new bear.

Now calling for a new cyclical bear market in stocks is not something that
can be done lightly. Material selloffs that ultimately grow big enough to exceed
20% only happen in very specific conditions. I didn't even start thinking
about one until a year ago. Back in mid-2011 halfway through the last major
correction, I even actively
argued against a new cyclical bear. Cyclical bears are only born when
cyclical bulls mature.

The really ominous thing today is our current cyclical bull is long past mature.
It has lasted much longer and risen much farther than average, which is the
real reason a new stock bear looms. While Wall Street and the vast majority
of investors are loath to admit it, we remain mired deep within a secular
bear. These are simply very long consolidations, where the stock markets
grind sideways for a whopping 17 years.

Stock markets move in great third-of-a-century cycles I call Long
Valuation Waves. The first half of each single wave is a secular stock
bull, and the second half a secular stock bear. The entire reason the bear
half exists for those 17 long years is to allow stock-market valuations to
mean revert from excessive highs at the ends of the preceding bull. Like
all major market reversions, they overshoot before the bear ends.

These secular bears force stock markets to grind sideways on balance,
giving underlying corporate earnings time to catch up with high stock prices.
Mechanically this happens through a series of shorter cyclical bears and cyclical
bulls within the secular-bear span. It is nearly impossible to be a
successful investor if you don't understand these secular and cyclical cycles
and their impact on stock prices.

This next chart shows our current SPX secular bear superimposed over the last
one between 1966 and 1982. This perspective is invaluable yet hard to find,
the financial media almost never talks about it. Wall Street perpetually tries
to convince investors that anytime is a great time to buy stocks. But
the investors who foolishly buy general stocks high near the ends of mid-secular-bear
cyclical bulls get slaughtered.

The past 13 years' secular bear dominates the long-term SPX charts,
it is undeniable. Stocks have simply ground sideways at best since the
last secular bull topped in March 2000. While the financial media has been
elatedly celebrating new record highs this year, at best the SPX was only up
11.9% over the 13.4 years between March 2000 and August 2013. This compounds
to about a 0.85% annual return.

Earning capital gains in the general stock markets of less than 1% per year
at best for over 13 years is horrendously bad. Factor
in inflation, and there were actually big real losses. Dividends helped
offset some of these, but overall the long-term investors who stayed invested
throughout this secular bear have still suffered substantial losses at best.
Secular bear markets are brutally unforgiving, eviscerating the naive.

Their sideways grinds are a series of cyclical bears and bulls. The cyclical
bears generally cut stock prices in half, and then the subsequent cyclical
bulls generally double them again back up to their starting point. So while
secular bears slaughter buy-and-hold investors, they are very profitable to
trade. The key is buying stocks when they near secular support, then selling
later when they hit secular resistance.

Secular support and secular resistance on the SPX are around 750 and 1500
respectively. Support is hit after mid-secular-bear cyclical bears, and resistance
is hit after mid-secular-bear cyclical bulls. Like any technical lines, these
are zones and not hard limits. The SPX can overshoot in both directions, but
not for long. Soon the dominating secular trading range reasserts itself and
sucks the SPX back into its maw.

In late January 2013, the SPX broke above this 1500 secular resistance. In
late March, it edged up to new all-time nominal highs (though it had and still
remains far
from real ones). The last mighty cyclical bull topping in October 2007
overshot as well, but soon succumbed to the unyielding secular bear. So not
even 1700 on the SPX gets us out of the woods until the bear's mission has
been accomplished.

And that is to force the stock markets to trade sideways for long enough for
valuations to plunge from extremely overvalued to extremely undervalued levels.
In P/E-ratio terms, secular bears are born at general-market valuations above
28x earnings (twice the 14x long-term
fair value) and end around 7x earnings (half fair value). Today's secular
bear won't end until the SPX hits 7x earnings once again.

When it was born way back in early 2000, the SPX traded in a spectacular bubble
at 43.8x. 7.6 years later in October 2007 when the last cyclical bull topped,
its P/E ratio had fallen to 21.3x. While the SPX was at the same levels, corporate
earnings had grown enough to cut valuations in half. But stocks were still
very expensive. Even during those epic stock-panic lows in early 2009, the
SPX only fell to 11.6x at worst.

That was 9.0 years into this secular bear, and the best chance the stock markets
had to hit those 7x secular-bear-ending levels. They failed, virtually assuring
this valuation-driven secular bear would continue for its entire 17-year normal
duration. Today 13.4 years into that span, the SPX is once again at the
same high topping
valuation of 21.2x seen in late 2007. Its work far from done, this secular
bear is far from over.

Greatly amplifying the danger today, the SPX is not only far above its secular-bear
resistance of 1500 but the current cyclical bull has powered far too high for
far too long. It is up an astounding 152.7% over 4.4 years (or 53 months)!
Meanwhile the average size and duration of modern mid-secular-bear
cyclical bulls is only a doubling over 35 months. The more excessive the
extreme, the bigger and faster the mean reversion.

The secular bear that has been plaguing the stock markets since early 2000
hasn't even come close yet to accomplishing its mission. Today's stock-market
valuations are three times higher than the 7x target, and even at their
lowest point in early 2009 were still 2/3rds higher. And this secular bear
still remains several years away from hitting their tight average duration
of 17 years. It hasn't had sufficient time to mature yet.

So as you can see, the US stock markets are in an extraordinarily dangerous
place today. They are very overdue for a selloff, and that almost certainly
has to grow into a major correction to rebalance sentiment. And one or two
sizable down days late in a major correction when sentiment is dismal is all
it takes to push the SPX over that 20% threshold into cyclical-bear territory.
These ultimately cut stock prices in half!

With today's stock markets euphoric and overbought, with the recent years'
cyclical bull way too old and too high, investors and speculators alike have
to be exceedingly careful in the months to come. Wall Street will deny the
coming selloff is meaningful every step of the way down, lulling traders into
false security until it is way too late. You need proven battle-hardened contrarians
to help you navigate this transition.

That's us at Zeal. We've spent decades intensely studying and trading the
markets. We buy low when others are afraid and then later sell high when others
are brave. Fighting the crowd has proven wildly successful. As of the end of
June, we've recommended and realized 655 stock trades to our newsletter subscribers
since 2001. They averaged stellar annualized realized gains of +28.6% during
a secular bear!

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The bottom line is the US stock markets are overdue for a material selloff
after their massive levitation this year. And this has to snowball into a full-blown
correction since it has been so anomalously long since the last one. Today's
euphoric sentiment will be so ravaged by the time that correction hits the
high teens that it won't be hard for it to edge over 20% into cyclical-bear
territory. That will push the selloff target to 50%ish!

A new stock bear looming is far from a radical idea, it is merely a high-probability
mean reversion. The ongoing secular bear remains too young to give up its ghost,
and far from accomplishing it valuation mission. Valuations remain very expensive,
while the SPX's cyclical bull is extremely overextended in both magnitude and
duration terms. In light of all this, it's hard to imagine a new stock bear
not being born.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
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